Comparing performance when invested capital is low

Return on capital is the benchmark for comparing performance between businesses. But new math is needed when a company’s capital intensity is low.

October 2005| byMikel Dodd and Werner Rehm

Executives and investors have reliable tools for measuring performance in capital-intensive sectors such as manufacturing, retailing, and consumer goods. In general, the math is simple: when managers generate returns on invested capital (ROIC) above their cost of capital, they create value. That formula makes it relatively easy to compare the creation of value among business units or between companies.

But what if the invested-capital side of the equation approaches zero, as it increasingly does among companies that use outsourcing and alliances and thus reduce the capital intensity of parts of their businesses? Other businesses, such as software development and services, also have inherently low capital requirements or take advantage of atypical working-capital dynamics, including prepayment by customers for licenses and payment by suppliers for inventory. Even traditional businesses are shedding capital: the median level of invested capital for US industrial companies dropped from around 50 percent of revenues in the early 1970s to just above 30 percent in 2004.11.
This statistic is based on a McKinsey analysis of more than 600 companies with sales greater than $100 million. The classification of a company as an industrial one is based on the Compustat CIGS classification system, jointly launched by Standard & Poor’s and Morgan Stanley Capital International (MSCI) in 1999.

When a company’s or a unit’s business model doesn’t call for substantial capital or even involves negative operating capital, the ROIC is usually extremely large (whether positive or negative), very sensitive to small changes in capital, and highly volatile and thus often inappropriate as a tool for comparing the performance of business units or companies. What’s more, executives who continue to use ROIC as their main point of comparison are likely to measure and manage performance unproductively. They might hesitate to invest additional resources in low-capital businesses (Exhibit 1) or, still worse, ignore capital altogether and focus on margins alone as the primary performance metric.

Exhibit 1

A more useful way to measure performance is to divide annual economic profit by revenue.22.
Economic profit is typically defined as a company’s posttax operating profit minus a capital charge, calculated as the company’s weighted average cost of capital (WACC) multiplied by the operating invested capital. See Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, fourth edition, Hoboken, New Jersey: John Wiley & Sons, 2005, pp. 182–8, for more information about calculating ROIC and economic profit. Grounded in the same logic as conventional ROIC and growth measures,33.
The present value of economic profit plus invested capital yields the same enterprise value as formulas based on ROIC and growth and discounted-cash-flow models. this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn’t make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Same company, different economics

A large European industrial conglomerate provides an example of the difficulties of using ROIC to compare business units with different levels of capital intensity. The company’s executive board decided to take advantage of a trend in traditional industries toward adopting the next generation of process automation software and services by launching a business unit that exclusively offered software solutions based on standard off-the-shelf hardware. The new business naturally had a low level of invested capital, since its assets were essentially people and no manufacturing was involved. The willingness of customers to pay in advance for software development moved the level of operating invested capital below zero.

But while the move made strategic sense, operational reviews among the conglomerate’s business units became meaningless. Executives insisted on comparing them only on the basis of ROIC and growth performance, which meant that much time was spent arguing about the negative ROIC of the new business and whether it created or destroyed value and was on track to become a profitable undertaking. Nobody could assess the performance of the software business against that of the conglomerate’s traditional businesses. Discussions about the allocation of resources became heated—in particular because the growing software business needed to hire staff while older units were cutting back.

Since business models within a single industry may diverge, similar problems bedevil many executives trying to compare overall corporate performance. A US high-tech manufacturer that pursued an aggressive facility-outsourcing strategy combined with a just-in-time inventory system eventually drove its invested capital below zero. As a result, the company’s ROIC was negative and therefore meaningless. A direct competitor also acted to improve its efficiency but kept its manufacturing assets in house. This decision left it with significantly higher levels of invested capital but also with higher margins. It thus had a substantial positive—and meaningful—ROIC, which made apples-to-apples comparisons between the two companies impossible. Furthermore, the ROIC of the first company fluctuated wildly, as minor changes in its invested capital sharply altered the results of the ROIC calculations.

Board members and investors of this first company frequently wondered if it was outperforming its competitor and wanted to know how management was judging the performance of its strategy and business model. In frustration, the company’s executives and board increasingly focused on margins as their key operating metric. But the appropriate level of margins for their low-capital strategy was difficult to judge. They recognized that a business whose capital intensity was low as a result of outsourcing should have lower margins than one that retained its manufacturing assets and thus substantial capital, but they struggled to determine how low a level was reasonable.

A different measure

To understand how a metric based on economic profit and revenue can eliminate such distortions in measuring value, consider a hypothetical company with three business units, each with $1 billion in revenue (Exhibit 2, part 1). Two newer business units—a software business and a services business—have very low or negative invested capital. The company’s more asset-heavy traditional business can extract a profit margin of 12 percent (compared with 7 percent for the other units) because it doesn’t outsource any parts of the value chain and has an established, captive customer base that faces high switching costs. It is growing more slowly, however—by 4.5 percent a year, compared with 6 percent for the new businesses.

Exhibit 2

Using these data, the return on capital for the software business is a negative 700 percent while the ROIC of the services business is a positive 700 percent, even though the actual difference in the invested capital of the two units is only 2 percent of revenue. The traditional business has a 30 percent ROIC. A conventional evaluation of performance would compare the two newer businesses on the basis of their margins (because their capital is so small as to be deemed meaningless) and scold the traditional business for its high capital intensity.

That kind of approach can lead to serious misjudgments of the value created by the three units and to the misallocation of resources among them—as indicated by the fact that the traditional business has the highest value of the group, even though it has the lowest growth rate (Exhibit 2, part 2). How can this result be reconciled with the observed returns on capital in order to compare the true fundamental performance of the three units? It turns out that in this case, ROIC tracks the creation of value much less accurately than does economic profit divided by revenue. According to that measure, the economic performance of the three units is remarkably similar. All are creating value in absolute terms (all the ratios are positive), and they are creating value at a similar rate, with the traditional business slightly ahead.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.44.
Economic profit in the example falls by WACC times the change in capital, or $1 million. The value of the business falls to $1.720 billion, from $1.735 billion, on this change.

Using the same approach, consider again attempts to compare the operating performance of the US high-tech manufacturer with that of its direct competitor (Exhibit 3). Owing to the high-tech company’s negative invested capital (a result of the outsourcing strategy), ROIC comparisons were meaningless. Margin comparisons were also tricky; a company that outsources would be expected to have lower margins than one that holds on to all parts of the value chain. But an analysis using economic profit divided by revenue made it clear that the outsourcing strategy as implemented wasn’t as successful as had been hoped; the high-tech company was still generating less value per unit of revenue than its competitor.

Exhibit 3

Executives of the large European industrial conglomerate mentioned previously ultimately decided to use economic profit, combined with value targets based on economic-profit-discounting models, as its measure for success. While this approach required a significant investment in training, the change reflected management’s goal of a consistent measure for value creation across capital-light and capital-heavy units.

Returns on capital will always be an essential metric for managers. Yet in businesses with low levels of invested capital, replacing ROIC with economic profit divided by revenue will make internal and peer comparisons much more meaningful.

About the authors

Mikel Dodd is a partner and Werner Rehm is a consultant in McKinsey’s New York office.

This article was first published in the Autumn 2005 issue of McKinsey on Finance. Visit McKinsey’s corporate finance site to view the full issue.

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